This week, the World Bank Group announced its new Climate Change Action Plan, with a range of commitments to ramp up and deliver record levels of climate finance, while catastrophe bonds, disaster risk financing and insurance against climate risk are also mentioned
Through its new Climate Change Action Plan, the World Bank is targeting the delivery of record levels of climate financing to developing countries.
At the same time the World Bank aims to work to reduce emissions, strengthen adaptation and align financial flows within the work it does with the goals of the Paris Agreement on climate change.
The global insurance protection gap, or the gap between economic losses and those that are insured, widened in 2020 as pandemic related effects drove global macroeconomic resilience to decline by 18%, according to a measure by reinsurance firm Swiss Re.
Swiss Re Institute has published its Resilience Index, which shows that the COVID-19 pandemic reduced global macroeconomic resilience by close to a fifth in 2020.
Global economic growth is expected to recover strongly in 2021, after the pandemic-induced recession in 2020, thee reinsurance firm said, which it expects will help to build macroeconomic resilience again.
However, Swiss Re warns that “there will not be a return to pre-COVID-19 levels of resilience in 2021.”
With the BRI, new infrastructure have been constructed. But natural disasters can threaten large infrastructure projects and create financial turmoil in developing countries along the new Silk Road. Insurance-Linked Securities can mitigate this risk, but local authorities need to know more about this tool.
The protection gap, the difference between economic and insured losses, is a damning reflection on both the insurance market and those responsible for managing risk. Protection gaps exist in both developed and emerging markets, but where catastrophe risk coverage is around 35% in developed markets, it is just 6% in developing countries. According to AON, last year brought $268 billion of economic losses from natural disasters of which, just $97 billion was insured. Developing counties suffered a disproportionate share of uninsured losses, where damage sustained by businesses and governments are only increasing following a decade-long rise in natural catastrophes linked to climate change.
The long-term impacts of natural disasters are not predetermined, and the overall effect depends on the vulnerability of a country’s infrastructure, their access to disaster risk financing, and resilience. With inadequate insurance programs and a lack of alternatives, vulnerable countries (and sometimes even regions) have to rely on handouts from multilateral agencies and global development aid. However, such aid is reactive by nature, and payments can be slow to materialise. According to critics, there are also question marks around who the true beneficiaries of development aid are. Disasters do not just destroy homes, factories, and agricultural land in the short-term; they can annihilate years of economic growth.
Traditional indemnity insurance has been used for hundreds of years and to great effect. However, some of its limitations have started to surface over the last decade. For example, subjectivity around policy wordings has led to disputes in the courts spanning months, if not years, delaying disaster recovery and impacting affected parties further. The validity of traditional insurance is not being questioned by any means, but its suitability on a macro level in developing countries is. For example, in former Soviet Union countries, insurance in its traditional form is not suitable because sovereigns are responsible for critical infrastructure (therefore lack insurable interest).
When a natural disaster strikes, immediate steps need to be taken to protect survivors and provide them with temporary shelter, food, and water. Moreover, in the medium to long-term, homes, places of employment, and critical infrastructure such as schools and hospitals need to be rebuilt. In developed nations, government bodies such as FEMA in the USA typically act fast and provide these things. However, the same cannot be said for less developed markets. This is where Insurance-Linked Securities could make a significant contribution.
The renowned Chinese Belt and Road Initiative (BRI) is a perfect example where ILS could help transfer industrial and sovereign risk to the capital markets. China, through loans, has invested tens of billions of dollars in infrastructural development in Central Asia and other neighboring regions. Despite these regions having significant exposure to natural disasters, most of these new developments aren’t adequately insured.
The historical record of large disasters in the western BRI transit countries goes back to ancient Greece, where an earthquake in Crete destroyed Alexandria. More recently, in XX century earthquakes devastated Almaty (1911), Ashgabat (1948), Skopje (1963), Tashkent (1966), Bucharest (1977) and Spitak (1988). Floods, as well, has been an issue: from destruction of Pest in Hungary in 1838 to losses equating to 5-15% GDP of suffered countries during 2014-2016 Balkans Floods. In fact, close to 1/3 of the capitals of the ECIS countries have been at one time or another devastated by earthquakes or/and floods.
However, the issue isn’t only the physical damage from natural disasters themselves but also the repayment of loans. For example, if an earthquake in Central Asia destroyed a major logistics hub, not only will they suffer from business interruption, but also they still have to pay back the loans. Without adequate insurance, countries will have to foot the bill, and they might be worse off than before. The best way to avoid this scenario is to transfer their risk to the capital markets.
When Hurricane Maria struck the island of Puerto Rico in 2017, its people were without clean food and water for more than six months, 98% of buildings were either damaged or destroyed, and it took a further 11 months for power to fully restore on the island. If a parametric catastrophe bond programme or similar ILS solution was in place, capital could have flowed back into the economy sooner, and a return to their baseline would have been faster. Traditional insurance products, of course, still have a role to play, but ILS are perfectly suited to those who require fast injections of capital. This correlates with the United Nations’ argument that the speed of recovery really matters if a developing country is to minimise the long-term impacts of natural disasters on economic growth and productivity.
Furthermore, this type of disaster financing is far more efficient than traditional forms of insurance. Rather than waiting for loss adjusters and surveyors to assess the damage, ILS can provide immediate liquidity to governments that need it the most. In the diagram below, we have a countries baseline trend of economic growth. Common sense suggests that a destruction of capital will lead to an inability to produce goods and services, and growth will fall. The economy would recover, but given the long-term implications of damaged infrastructure and productivity, the trajectory of growth will be lower than before.
However, (and this is where ILS comes in) neoclassical economic growth theory would suggest that lower levels of capital might allow for higher productivity gains. By introducing a transparent, fast paying insurance-linked security like a catastrophe bond, economic growth and productivity could return to or exceed the baseline faster than if traditional insurance was in place. These capital flows help to address humanitarian crises, the rebuilding of infrastructure, and the creation of jobs. By stipulating that the bond proceeds must be spent on redevelopment projects, governments can focus on building back better and replacing old and weak infrastructure with buildings that conform to updated code.
So far, government pools such as the Caribbean Catastrophe Risk Insurance Facility (CCRIF) and Africa Risk Capacity (ARC) have illustrated the benefits of pooling regional risk and leveraging ILS. A recent example is the CCRIFs payment of $10.7m to Nicaragua after Tropical Cyclone Eta. Although this may seem a small amount in dollar terms, payment was made within 14 days. These fast injections of capital can often be the difference between life and death.
However, for the Eurasia transit countries, regional pools like the CCRIF and Pacific Alliance or World Bank contingent credit aren’t viable options because of the region’s geopolitical fragmentation. Underdeveloped insurance markets, low insurance penetration, and protectionism (restricted market access for international players) in several countries also make insurance placements a challenge at the macro level, unfortunately.
At the same time use of ILS for disaster risk transfer in the form of sovereign parametric catastrophe bonds is a neutral and feasible option, advantageous to beneficiaries and investors.
Catastrophe bonds are transparent, objective, and payouts are typically fast, making them ideal for critical infrastructure that a country might rely on to drive its GDP if disaster occurs. Furthermore, they can also help countries with a low credit rating that would typically struggle to source traditional financing or rely on slow/unreliable global development aid.
A better understanding of ILS can help traditional markets and governments transfer risk more efficiently. The lack of government understanding around ILS also does not help, so bridging the education gap is vital.
Multinational agencies like the World Bank and the United Nations Development Programme (UNDP) are doing an excellent job promoting products such as parametric insurance and instruments that transfer risk to the capital markets. However, their involvement alone is not enough. We believe that industry participants, associations, and, more importantly, academia need to join forces in a dedicated effort to educate local market participants, opinion leaders, and government officials to help them make better decisions.
Moreover, convergence between insurance and the broader capital markets is relatively straightforward in terms of legislation and local frameworks. If a country has already utilised the capital markets through sovereign bond issuance, it can do the same for disaster risk financing without any additional constraints.
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ARTEMIS: The efforts of the World Bank around disaster risk financing for its members continues to be a real benefit, and while the organisation can and will do more, this isn’t about being the dominant force in the market, according to Michael Bennett, Head of Derivatives & Structured Finance, World Bank Treasury.
During last month’s annual ILS conference in New York City, held virtually for the first time owing to restrictions, Artemis spoke with Bennett about the World Bank’s use of reinsurance and insurance-linked securities (ILS) structures for member governments, and how this might evolve in the future.
The Pacific Alliance, a Latin American trade bloc made up of Chile, Colombia, Mexico and Peru, would like to expand on the coverage provided by their catastrophe bonds, with hydro-meteorological risks including tropical cyclones, drought, floods and even cold weather all mooted as potential perils to include.
The Ministries of Finance of the Pacific Alliance members met in late 2020 to discuss next steps in their disaster risk financing and catastrophe bond journey.
The World Bank has “only scratched the surface” on what it can do with member governments that are looking to transfer some of their disaster risk to the reinsurance sector and the capital markets, according to Michael Bennett, Head of Derivatives & Structured Finance, World Bank Treasury.
The World Bank is an international organisation with 189 member governments. Through the use of both traditional reinsurance and the issuance of catastrophe bonds, a sub-sector of the insurance-linked securities (ILS) space, it helps its members transfer disaster risk to the markets.
The focus of the Treasury Department of the World Bank is often the tail-end of a broader engagement with a given member designed to assess and quantify their disaster risk.
Jamaica continues to work with the World Bank on a first catastrophe bond for the country the Finance Ministry has said and reflecting the importance of disaster risk financing, in recent weeks it has received a roughly $3.5 million payout under its parametric CCRIF insurance coverage.
The payout comes after the torrential rainfall from tropical cyclones Zeta and Eta impacted the Caribbean island nation triggered the parametric excess rainfall protection that Jamaica has.
The CCRIF SPC (formerly known as the Caribbean Catastrophe Risk Insurance Facility) provides excess rainfall parametric insurance coverage, as well as parametric risk transfer for peak perils such as hurricanes and earthquakes.
Mexico’s still in-force $485 million IBRD / FONDEN 2020 catastrophe bond will continue to provide the country with important disaster insurance protection, as the beneficiary of the cover has been shifted away from the shuttered FONDEN disaster fund to the country’s Treasury.
We’re told that a notification has been sent to investors in and holders of the World Bank issued Mexican catastrophe bond, to explain that the coverage it provides will continue uninterrupted, despite Mexico’s Fund for Natural Disasters (El Fondo de Desastres Naturales), more commonly known as FONDEN, having been dismantled.
As we reported last October, FONDEN was set to be dismantled after Mexico’s lawmakers in the senate voted to reform that area of public funding.
Central Asian countries will benefit from a better understanding of their natural disaster risks, which in time could lead to greater use of risk transfer, insurance and reinsurance capacity in the region, as the World Bank supports a multi-peril risk assessment project for the region.
One of the first steps in moving towards sovereign disaster risk transfer, such as use of insurance, reinsurance or catastrophe bond type arrangements, tends to be in the development of risk modelling tools to enhance the understanding of exposures in a country.
To that end, the World Bank, alongside its partners, has launched an initiative to provide a multi-peril risk assessment of natural disaster risks, including earthquakes, floods and selected landslides within the Central Asia region.
The World Bank has approved $500 million of funding for Indonesia to help the country enhance its financial response to natural disasters, climate risks, and health-related shocks, with the use of risk pooling, and insurance or reinsurance instruments at the heart of the plan.
Between 2014 and 2018, the central government of Indonesia has spent between US$90 million and US$500 million annually on disaster response and recovery, the World Bank explained, while Indonesia’s local governments spent an estimated additional $250 million over the same period.
With the cost of natural disasters and severe weather events expected to keep increasing further due to climate change and also urban growth, the World Bank notes that these costs will pressure Indonesia’s government public spending.